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book Page 53 Wednesday, December 21, 2011 9:06 AM

A Supply Model of the Equity

Richard C. Grinold
Former Managing Director
Barclays Global Investors

Kenneth F. Kroner
Managing Director

Laurence B. Siegel
Research Director, Research Foundation of CFA Institute
Senior Advisor, Ounavarra Capital LLC

The equity risk premium (ERP) is almost certainly the most important variable
in finance. It tells you how much you need to save, how much you can spend,
and how to allocate your assets between equities and bonds. Yet, recognized
experts cannot agree on the ERP’s value within an order of magnitude or even
agree whether it is negative or positive. At a 2001 symposium, the predecessor
of the one documented in this book, Robert Arnott and Ronald Ryan set forth
an ERP estimate of –0.9 percent and Roger Ibbotson and Peng Chen proposed
+6 percent.1 The estimates in this book are much more tightly clustered, but
considerable disagreement remains about how to estimate the premium as well
as its size.
Grinold and Kroner (2002) proposed a model of the ERP that linked equity
returns to gross domestic product (GDP) growth.2 The key insight, which
draws on earlier work by a number of authors, was that aggregate corporate
profits cannot grow indefinitely much faster—or much slower—than GDP.
(And as Herbert Stein was fond of reminding us, any economic trend that
cannot continue forever will not.) If profits grow faster than GDP, they
eventually take over the economy, leaving nothing for labor, government,
natural resource owners, or other claimants. If profits grow more slowly than
1 See Arnott and Ryan (2001); Ibbotson and Chen (2003). The Ibbotson and Chen estimate of
6 percent is an arithmetic mean expectation; their geometric mean expectation was 4 percent.
2 A second printing of this article, from March 2004, is available online at

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Rethinking the Equity Risk Premium

GDP, they eventually disappear and businesses will have no profit motive to
continue operating. Thus, in the very long run, the ratio of profits to GDP is
roughly constant.
The title of this paper, a shortened and updated version of Grinold and
Kroner (2002), refers to the “supply model” of Diermeier, Ibbotson, and Siegel
(1984), who differentiated between the demand for capital market returns (what
investors need to compensate them for risk) and the supply of returns (what the
macroeconomy makes available). The original supply model likewise made use
of a link between profits and GDP. Grinold and Kroner (2002) was titled “The
Equity Risk Premium: Analyzing the Long-Run Prospects for the Stock
Market,” but the similarity with the title of this book forced us to rename the
current paper. Although our method is designed to produce an ERP estimate
that reflects both supply and demand, the link to macroeconomic performance
gives it a supply-side flavor.3
When we revisited the estimates from Grinold and Kroner (2002), we
found that not all the components could be updated with equal accuracy, so the
ERP estimate provided here is subject to some important caveats regarding data
adequacy. The method that we recommend, however, remains largely
unchanged from Grinold and Kroner (2002).

The Equity Risk Premium Model

We define the equity risk premium as the expected total return differential
between the S&P 500 Index and a 10-year par U.S. government bond over the
next 10 years. Our forecast of the return to the 10-year government bond over
the next 10 years is simply the yield on that bond. Therefore, the ERP becomes
E  RS  RB  = Expected S&P 500 return  10-year bond yield . (1)
A purer and more “modern” approach is to conduct the whole analysis in
real terms and to use the yield on a 10-year par Treasury Inflation-Protected
Securities (TIPS) bond or, alternatively, a 10-year TIPS strip as the relevant
bond yield. The authors of some of the other papers in this book do just that.
We estimate the ERP over 10-year nominal bonds, however, because that is
what Grinold and Kroner (2002) did. The numerical difference between the
results of the two methods, real and nominal, is not large.
Forecasting the return on the S&P 500 over the next 10 years is more
difficult and, therefore, gets most of the attention in this paper. The framework
we use is to decompose equity returns into several understandable pieces and
then examine each piece separately.
3 A more detailed history of the estimation of the ERP can be found in the foreword (by Laurence
B. Siegel) in Kaplan (2011).

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A Supply Model of the Equity Premium

The return to equities over a single period can always be broken down as
RS  Income return  Nominal earnings growth  Repricing. (2)
The income return is the percentage of market value that is distributed to
shareholders as cash. If dividends are the only source of income, then the income
return is equivalent to the dividend yield. Today, share repurchase programs
(buybacks) are another common means of distributing cash to shareholders.
Cash takeovers (by one company of another) should also be counted in the
income return of an index that includes the stock of the acquired company.
The next two terms in Equation 2 represent the capital gain. Capital gains
come from a combination of earnings growth and P/E expansion or contraction,
which we call “repricing.”
For expository purposes, we decompose the components further and use
more precise notation. The return over a single period is
R  S  i  g  PE .
  
  
 
Income Earnings growth Repricing

The first term, D/P, is simply the dividend yield. The second term, –S,
is the percentage change in the number of shares outstanding. The percentage
change in the number of shares outstanding equals the “repurchase yield”
(which theoretically also includes cash takeovers) minus new shares issued
(dilution); it has a negative sign because a decrease in the number of shares
outstanding adds to return and an increase subtracts from return.4 Together,
the terms D/P and –S measure the fraction of market capitalization that the
companies in an index, in aggregate, return to shareholders in cash. Therefore,
we refer to the sum of these two terms as the “income return.”
The remaining terms, i + g + PE, make up the capital gain. The term i
represents the inflation rate. The term g is the real earnings (not earnings per
share) growth rate over the period of measurement. The final term, PE, is
the percentage change in the P/E multiple over the period. We refer to this
last piece as the “repricing” part of the return.
4 Share buybacks may be viewed as either a component of income return or a component of capital
gain. An owner of a single share who holds on to the share through the share buyback program
experiences the buyback as a component of capital gain because the same earnings are divided
among fewer shares, which causes EPS to rise although earnings (not per share) have not
changed. If the stock’s P/E and all other factors are held equal, then the stock price rises. An
index fund investor, however, experiences the share buyback as cash income because the index
fund manager—who tenders some of the shares to the issuer to keep the stock’s (now decreased)
weight in the fund proportionate to its weight in the index—receives cash, which is then
distributed to, or held by, fund shareholders like any other cash (tax considerations aside). We
choose to view share buybacks as a component of income return.

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Rethinking the Equity Risk Premium

It is important to realize that this decomposition of returns is essentially an

identity, not an assumption, so any view on the equity risk premium can be mapped
into these components. To illustrate, if the current 10-year bond yield is 3 percent,
anyone who believes that the ERP is currently 4 percent must believe that the
income return, nominal earnings growth, and repricing sum to 7 percent.

Historical Returns
Let us briefly consider what risk premium markets have provided historically.
Over the last 85 years (1926–2010), the U.S. stock market and the intermediate-
term U.S. Treasury bond market have delivered compound annual nominal
returns of 9.9 percent and 5.4 percent, respectively.5 Thus, the realized pre-
mium that stocks delivered over bonds was 4.5 percent.6 The historical return
decomposition in Table 1 can be used to better understand this 9.9 percent
annual equity return.
The income return (through dividends only, not share buybacks) on the
S&P 500 was 4.1 percent annualized over this 85-year period. In this decom-
position, we adjusted earnings growth for increases in the number of shares to
arrive at earnings per share (EPS) growth. EPS grew at a rate of about 4.9 percent
per year (1.9 percent real growth and 3.0 percent inflation) over the period.

Table 1. Decomposition of Total Returns on the

S&P 500,a 1926–2010
Income return 4.10%
Real EPS growth 1.91
Inflation 2.99
P/E repricing 0.58
Within-year reinvestment returnb 0.28
Total return 9.87%
aS&P 90 from January 1926 to February 1957; S&P 500 from
March 1957 to 2010.
bReinvestment of dividends paid during the year in the capital gain
index (which consists of real EPS growth plus inflation plus P/E
Source: Morningstar/Ibbotson (used by permission).

5 See the data for large-company stocks (i.e., the S&P 90 from January 1926 through February
1957 and the S&P 500 thereafter) in Table 2.1 in Ibbotson SBBI (2011, p. 32). Returns are
before fees, transaction costs, taxes, and other costs.
6 This amount is the arithmetic difference of geometric means. The geometric difference of
geometric means, or the compound annual rate at which stocks outperformed bonds, is given by
(1 + 0.099)/(1 + 0.054) – 1 = 4.27 percent.

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A Supply Model of the Equity Premium

The remainder of the total return on equities was due to repricing. The
P/E of the market, measured as the end-of-year price divided by trailing
12-month earnings, grew from 11.3 at year-end 1925 to 18.5 at year-end
2010.7 This repricing works out to an additional return, or P/E expansion, of
0.58 percent per year. A common view is that this P/E expansion was
understandable and reasonable in light of the technological and financial
innovations over this long period. For example, accounting standards became
more transparent (recent “fraud stocks” notwithstanding). Such innovations
as the index fund made it easier for investors to diversify security-specific risk
and to save on costs. Mutual fund complexes provided easier access to institu-
tional-quality active management. Finally, many market observers perceive the
business cycle to have been under better control in recent decades than it was
in the 1920s and 1930s, which made expected earnings smoother; the recent
near depression and quick recovery, at least in corporate profits and the stock
market, support this view somewhat. All these factors have made equity
investing less risky and contributed to the repricing over this 85-year period.
But the presence of these factors in the past does not mean that we should
build continued upward repricing into our forecasts. We consider this issue later
in this paper.
Chart 1 of Grinold and Kroner (2002) further dissects the return decom-
position into annual return contributions. Their graph demonstrates that the
noisiest component of returns is clearly P/E repricing, followed by real earnings
growth. Inflation and income returns are relatively stable through time. This
observation implies that our real earnings growth and repricing forecasts are
likely to be the least accurate and our inflation and income return forecasts are
likely to be more accurate.
Mehra and Prescott (1985), and many others, argued that the equity
premium of 4.5 percent was a multiple of the amount that should have been
necessary to entice investors to hold on to the risky cash flows offered by equities
instead of the certain cash flows offered by bonds. This contention spawned a
huge literature on the “equity risk premium puzzle.”8 We have always been
perplexed by a debate that suggests that investors were wrong while a specific
macroeconomic theory is right, but Rajnish Mehra sheds additional light on
this question elsewhere in this book.

7 Because earnings were growing very quickly at the end of 2010, the more familiar P/E calculated
as the current price divided by 12-month forward (forecast) earnings was lower than the P/E
shown here.
8 For surveys of this literature, see Kocherlakota (1996); Mehra (2003).

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Looking to the Future

Next, we will examine each term in Equation 3 to determine which data are
needed to forecast these terms over the moderately long run (10 years). Later
in the paper, we will combine the elements to estimate, or forecast, the total
return on the S&P 500 over that time frame. Finally, we will subtract the
10-year Treasury bond yield to arrive at the expected equity risk premium.
Income Return. The income return is the percentage of market capi-
talization that is distributed to shareholders in cash. Currently, companies have
two principal means of distributing cash to shareholders: dividend payments
and share repurchases. A third method, buying other companies for cash,
“works” at the index level because index investors hold the acquired company
and the acquiring company if the index is broad enough.
Until the mid-1980s, dividends were essentially the only means of distrib-
uting earnings. Since then, repurchases have skyrocketed in popularity, in part
because they are a more tax-efficient means of distributing earnings and in part
because companies with cash to distribute may not want to induce investors to
expect a distribution every quarter (and cutting dividends is painful and often
causes the stock price to decline). In addition, dividend-paying companies may
suffer from a stigma of not being “growth” companies.
In fact, according to Grullon and Michaely (2000), the nominal growth rate
of repurchases between 1980 and 1998 was 28.3 percent. Numerous other studies
have shown that share repurchases have surpassed dividends as the preferred
means of distributing earnings.9 According to Fama and French (2001), only
about one-fifth of publicly traded (nonfinancial and nonutility) companies paid
any dividends at the time of their study, compared with about two-thirds as
recently as 1978. So the “repurchase yield” now exceeds the dividend yield.
Currently (as of 18 March 2011), the dividend yield is 1.78 percent.10 Like
a bond yield, the current (not historical average) dividend yield is likely the best
estimate of the income return over the near to intermediate future, so we use
1.78 percent as our estimate of D/P in Equation 3.
To estimate the repurchase yield, we used historical data over the longest
period for which data were available from Standard & Poor’s, the 12 years from
1998 through 2009. We calculated the annual repurchase yield as the sum of a
given year’s share repurchases divided by the end-of-year capitalization of the
market. Table 2 shows these data. The average of the 12 annual repurchase
yields is 2.2 percent, which we use in our ERP estimate.
9 See, for example, Fama and French (2001); Grullon and Michaely (2000); Fenn and Liang (2000).
10 We obtained this number at on 18 March 2011.

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A Supply Model of the Equity Premium

Table 2. Repurchase Return of the S&P 500, 1998–2009

Year-End Market Share Repurchases Share Repurchase
Capitalization during Year Return
Year ($ billions) ($ billions) (%)
1998 9,942.37 125 1.26
1999 12,314.99 142 1.15
2000 11,714.55 151 1.29
2001 10,463.39 132.21 1.26
2002 8,107.41 127.25 1.57
2003 10,285.83 131.05 1.27
2004 11,288.60 197.48 1.75
2005 11,254.54 349.22 3.10
2006 12,728.86 431.83 3.39
2007 12,867.85 589.12 4.58
2008 7,851.81 339.61 4.33
2009 9,927.56 137.60 1.39
Average 2.20
Source: Standard & Poor’s.

It is possible to make the case for a much higher repurchase yield forecast
by giving greater weight to more recent information (which is basically what
we did with the dividend yield). According to Standard & Poor’s (2008), “Over
the past fourteen quarters, since the buyback boom began during the fourth
quarter of 2004, S&P 500 issues have spent approximately $1.55 trillion on
stock buybacks compared to . . . $783 billion on dividends.” Although buybacks
collapsed in 2009, they rebounded in 2010 and 2011. If the two-to-one ratio
of buybacks to dividend payments observed by Standard & Poor’s over 2004–
2008 persists in the future, the repurchase yield will be as high as 3.5–3.6
percent. Aiming for a “fair and balanced” estimate, we use the lower number,
2.2 percent, which we obtained by weighting all 12 years of historical share
repurchase data equally.11
We have not included cash buyouts in our estimate of the repurchase yield.
From the perspective of an investor who holds an index containing companies
A, B, C, and so forth, a cash buyout or takeover—a payment by company A to

11 The use of this lower number is neutral, not conservative in the sense of numerically
minimizing the ERP estimate. The reason is that there are offsetting biases. Our buyback
estimate of 2.2 percent is too high because we do not subtract the historical contribution of
buybacks to the dilution estimate (discussed later). And it is too low because very recent buyback
rates have been much higher than 2.2 percent, not to mention the fact that we fully ignore the
cash takeover yield.

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Rethinking the Equity Risk Premium

an investor holding shares of company B in exchange for a tender of those

shares—is no different from a share buyback, which is a payment by company
A to an investor holding shares of A in exchange for a tender of those shares.
Thus, the “cash buyout yield” needs to be added to the repurchase yield when
summing all the pieces of –S. However, we do not have data for cash buyouts.
If we did, they would increase our forecast of the equity risk premium (because
cash buyouts must be a positive number and no other component of the ERP
would change).
■ Effect of Dilution on Income Return. Dilution is the effect of new issu-
ance of shares by existing companies and takes place through secondary offer-
ings and the exercise of stock options. Dilution may be regarded as reflecting
capital that needs to be injected from the labor market (or from elsewhere) into
the stock market so investors can participate fully in the real economic growth
described in the next section. Formally, dilution (expressed as an annual rate or
a decrement to the total expected equity return) is the difference between the
growth rate of dividends and the growth rate of dividends per share. If the
payout ratio is assumed to be constant, dilution is also equal to the difference
between the earnings growth rate and the EPS growth rate.
Grinold and Kroner (2002) estimated dilution from secondary offerings
using historical data and dealt with stock options separately. Here, because we
do not have the data to properly update the dilution estimates in Grinold and
Kroner (2002), we use a shortcut: We directly adopt the 2 percent per year
dilution estimate from Bernstein and Arnott (2003).
Bernstein and Arnott (2003) studied U.S. stocks from 1871 to 2000 and
stocks from other countries over shorter periods. Instead of measuring the
difference between the growth rate of earnings and that of EPS, they used a
proxy: They measured the difference between the growth rate of total market
capitalization and the capital appreciation return (price return) on existing
shares. Dilution thus measured is net of share buybacks and cash buyouts (which
are forms of negative dilution because giving cash back to shareholders is the
opposite of raising capital by selling shares). The 2 percent dilution estimate
for U.S. stocks is supported by evidence from other countries.12
12 For a fuller discussion of dilution and an excellent description of the Bernstein and Arnott
(2003) method, see Cornell (2010), who wrote, “Bernstein and Arnott (2003) suggested an
ingenious procedure for estimating the combined impact of both effects [the need of existing
corporations to issue new shares and the effect of start-ups] on the rate of growth of earnings to
which current investors have a claim. They noted that total dilution on a marketwide basis can
be measured by the ratio of the proportionate increase in market capitalization to the value-
weighted proportionate increase in stock price. More precisely, net dilution for each period is
given by the equation Net dilution = (1 + c)/(1 + k) – 1, where c is the percentage capitalization
increase and k is the percentage increase in the value-weighted price index. Note that this dilution
measure holds exactly only for the aggregate market portfolio” (p. 60).

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We should subtract from the 2 percent dilution estimate that part of

historical dilution that was due to buybacks and cash takeovers (but not the part
of dilution that was due to stock option issuance because these cash flows went
to employees, not shareholders). We do not have the data to perform these
adjustments, however, so we do not attempt them. We simply use the 2 percent
estimate. (Note that the number of buybacks was tiny until the mid-1980s—
that is, over approximately the first 115 years of the 130-year sample—so
historical buybacks probably had a minimal impact on the average rate of
dilution for the entire period.)
■ Numerical Estimate of Income Return. The income return forecast con-
sists of the expected dividend yield, D/P, minus the expected rate of change in
the number of shares outstanding, S. The expected dividend yield is 1.78
percent. The number of new shares is expected to decline at a –0.2 percent
annual rate, consisting of 2 percent dilution minus a 2.2 percent repurchase
yield. After adding up all the pieces, the income return forecast is 1.98 percent.

Expected Real Earnings Growth. We expect real dividend growth,

real earnings growth, and real GDP growth—all expressed in aggregate, not in
per share or per capita, terms—to be equal to each other.
We expect dividend and earnings growth to be equal because we assume a
constant payout ratio. Although the payout ratio has fluctuated widely in the
past, it has trended downward over time, presumably because of tax and
corporate liquidity considerations. But the decline has effectively stopped.
Figure 1 shows the dividend payout ratio for the U.S. stock market for 1900–
2010; this curious series looks as though it has been bouncing between a
declining lower bound (which has now leveled off near 30 percent) and an
almost unlimited upper bound. The highest values of the payout ratio occurred
when there was an earnings collapse (as in 2008–2009), but companies are loath
to cut dividends more than they have to.13 The lower bound reflects payout
policy during normally prosperous times.
The current lower bound of about 30 percent would be a reasonable forecast
of the payout ratio, but we do not need an explicit forecast because we have
already assumed that it will be constant over the 10-year term of our ERP
estimate. It is helpful to have empirical support for our assumption of a constant
payout ratio, however, and the recent relative stability of the lower bound in
Figure 1 provides this support.
13 The all-time high level of the payout ratio, 397 percent, occurred in March 2009, when
annualized monthly dividends per “share” of the S&P 500 were $27.25 and annualized monthly
earnings per “share” were $6.86.

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Figure 1. Payout Ratio of the U.S. Equity Market, 1900–2010

Payout Ratio (dividends/earnings)









1900 10 20 30 40 50 60 70 80 90 2000 10

Source: Raw data are from Robert Shiller (,

as of 4 November 2011); calculations are by the authors.

We expect real earnings growth to equal real GDP growth for the macro-
consistency reason stated earlier: Any other result would, in the very long run,
lead to an absurdity—corporate profits either taking over national income
entirely or disappearing. Figure 2 shows the (trendless) fluctuations in the
corporate profit share of GDP since 1947.
These observations leave us with the puzzle of forecasting real GDP
growth. Grinold and Kroner (2002) engaged in a fairly typical macroeconomic
analysis that involved productivity growth, labor force growth, and the expected
difference between S&P 500 earnings and overall corporate profits. They did
not use historical averages or trends directly as forecasts; rather, they argued
that the data plus other factors justified the conclusion that real GDP would
most likely grow at 3 percent over the relevant forecast period and that real S&P
500 earnings would grow at 3.5 percent.
Real economic growth, by definition, equals real productivity growth plus
labor force growth. Although we can update the historical productivity and
labor force growth numbers, doing so would not produce an especially useful
forecast any more than it did for Grinold and Kroner (2002), who distanced
themselves somewhat from the productivity and labor force growth approach.
The reason is that extrapolating recent trends in these components of eco-
nomic growth can produce unrealistically high or low expectations, and using

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A Supply Model of the Equity Premium

Figure 2. Quarterly U.S. Corporate Profits as a Percentage

of GDP, 1947–2010

Profits/GDP (%)



47 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 01 04 07 10

Note: Profits are pre-tax.

Source: Haver Analytics, citing U.S. National Income and Product Accounts data.

historical averages provides no insight into possible future changes in the

components, which are important. Nevertheless, updates of these components
are provided for informational purposes in Figure 3.
We can, however, use a different decomposition of real economic growth,
which is also definitional: Expected GDP growth equals expected per capita GDP
growth plus expected population growth. We believe that population growth is
easier to forecast than labor force growth because the latter is partly endogenous
(e.g., people work longer if they need the money because of a weak economy).14
Figure 4 shows that since 1789, real per capita U.S. GDP has grown at a
fairly constant 1.8 percent compound annual rate. Cornell (2010) arrived at a
global estimate from the high-growth postwar period (1960–2006) that is
higher, but not dramatically so: 2.42 percent for mature economies and 2.79
percent for emerging economies. A cautious forecast is that the 1.8 percent
growth rate will continue. If this forecast entails substantial risk, it is to the
upside because an investment in the S&P 500 is not a pure bet on the U.S.
economy; many, if not most, of the companies in the index are global companies
that sell to markets that are growing more rapidly than the U.S. market.
14 Population growth is also partly endogenous (because the decisions of how many children to
have, whether to emigrate, and so forth, may depend on economic performance). These effects,
however, operate with long lags and tend to move the population growth rate slowly.

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Figure 3. U.S. Real Productivity and Labor Force Growth Rates, 1971–2009

Growth Rate (%)

Labor Force Growth Real Productivity Growth

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

Source: Organisation for Economic Co-Operation and Development, OECD StatExtracts (http://, as of 14 November 2011: total labour force, U.S., and labour productivity
annual growth rate, U.S.).

Figure 4. Real U.S. GDP per Capita, 1789–2008

Real U.S. GDP per Capita (2010 dollars)


1.8% Constant Growth Rate



1789 1819 1849 1879 1909 1939 1969 1999

Source: Data are from Robert D. Arnott.

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We add to the 1.8 percent real per capita GDP growth estimate the
Economist Intelligence Unit 10-year U.S. population growth estimate of 0.85
percent,15 which gives a total real GDP growth forecast of 2.65 percent. This
number is slightly below current consensus estimates.
This simplified method presents some difficulty because if the rate of
dilution is 2 percent at all population growth rates, then population growth has
a one-for-one effect on the estimate of the expected return on equities and,
therefore, on the ERP. This suggests an easy beat-the-market strategy: Invest
only in countries with the fastest population growth. This strategy has not
worked well in the past, and even if it did over some sample period, easy beat-
the-market strategies are usually illusory. Thus, the dilution estimate should
probably be higher for countries with high population growth rates or for a
country during periods of above-normal population growth. Although the logic
of using a link to real GDP growth to forecast the stock market has great
intuitive appeal, putting it into practice with any precision will take more work
and more thought regarding dilution.16
Expected Inflation. Because we are deriving the ERP relative to
Treasury bonds, we do not need our own inflation forecast as much as we need
an estimate of the inflation rate that is priced into the 10-year Treasury bond
market. Historical inflation rates have no bearing on this number, so we do
not present them. Fortunately, the yield spread between 10-year nominal
Treasury bonds and 10-year TIPS is a direct, although volatile, measure of the
inflation rate that is expected by bondholders. (The spread also includes an
inflation risk premium, present in nominal bond yields but not in TIPS yields,
for which we need to adjust.)
15 This number was obtained at on 2 May 2011 under
the heading “USA economy: Ten-year growth outlook” in the column “2011–20.” If we instead
used real productivity growth plus labor force growth to estimate real GDP growth, we would
get a slightly higher number for real productivity growth and a slightly lower number for labor
force growth, which would provide a very similar overall real GDP forecast.
16 Our simplified method has some other characteristics worth noting. It does not specifically
account for the wedge between population growth and labor force growth if the proportion of
retirees (or children) in the population is expected to change. A growing unproductive retiree
population should be considered bearish. Many would-be retirees, however, are not financially
prepared for retirement and, willingly or not, will work longer than they originally anticipated,
which contributes to GDP. In addition, in an advanced technological society, an aging
population distribution within the workforce is not all bad! We are accustomed to thinking of
young workers as productive and older workers as unproductive, but this is the case only in a
fairly primitive economy where the primary job description is something like “lift this and put it
over there.” In a technological society, young workers are unproductive—often startlingly so,
earning only the minimum wage—and older workers produce most of the added value and make
the lion’s share of the money. Nevertheless, young workers’ productivity grows quickly and older
workers’ productivity grows slowly or shrinks, so the impact of an aging workforce on rates of
change in productivity may be less salutary than the impact on the level of productivity.

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On 22 April 2011, the breakeven inflation rate (the yield spread described
above) was 2.60 percent.17 This rate is high by recent standards—it was as low
as 1.5 percent in September 2010—but it is typical of the longer history of the
series. Recent concerns about very high and rapidly growing levels of public
indebtedness (of the U.S. government, of local governments in the United States,
and of non-U.S. governments) have contributed to the increase in inflation
expectations. We subtract 0.2 percent for the inflation risk premium to arrive at
a 2.4 percent compound annual inflation forecast over the next 10 years.18
Expected Repricing. Grinold and Kroner (2002, p. 15, Chart 8)
conducted an analysis of the market’s P/E that led them to include a nonzero
(–0.75 percent per year) value for the repricing term, PE, in Equation 3. At
the time the analysis was conducted (November 2001), the market’s conven-
tional trailing P/E (price divided by one-year trailing earnings) was a lofty 29.7
and the “Shiller P/E” (price divided by 10-year trailing real earnings) was 30.0,
which prompted the authors to conclude that the P/E was likely to decline.19
(The Shiller P/E is designed to smooth out fluctuations caused by yearly
changes in earnings.) And decline it did.
Today, the situation is different. Figure 5 shows the conventional P/E and
the Shiller P/E of the U.S. market. Today’s conventional P/E of 18.5 is only
modestly higher than the very long-run (1900–2010) average P/E of 15.7, and
it is lower than the more recent long-run (1970–2010) average P/E of 18.9.
The Shiller P/E tells a slightly less favorable story: The current value is 22.4,
compared with an average of 16.3 over 1900–2010 and 19.2 over 1970–2010.20
Because it averages 10 years of trailing earnings, however, the current Shiller
P/E includes an earnings collapse in 2008–2009 that is almost literally unprec-
edented; even the Great Depression did not see as sharp a contraction in S&P
composite index earnings, although overall corporate profits in 1932 were
negative. (Huge losses in a few large companies, such as those that occurred in
2008–2009, go a long way toward erasing the profits of other companies when
summed across an index.) Only the depression of 1920–1921 is comparable.
Thus, we see no justification for using a nonzero value for the repricing term
in Equation 3. The market’s current level is already reflected in the (low)
dividend yield. To include a repricing term even though the dividend yield
already incorporates the market’s valuation is, theoretically, not double-counting
because the influence of the dividend yield is amortized over an infinite horizon,
17 See
18 This estimate of the inflation risk premium comes from Hördahl (2008, p. 31, Graph 2).
19 Shiller (2000) describes the Shiller P/E.
20 In this section, “current” values are as of December 2010.

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Figure 5. Conventional and Shiller P/Es for the U.S. Equity Market,



35 Shiller






5 Conventional

1900 10 20 30 40 50 60 70 80 90 2000 10

Note: The October 2009 conventional P/E equals 86.

Source: Spreadsheet available at Robert Shiller’s website (

whereas our forecast is for only the next 10 years. Thus, if we believe that the
market is mispriced in such a way that it will be fully corrected within 10 years,
a nonzero repricing term is warranted. Although Grinold and Kroner (2002)
argued that the market P/E was too high at that time and would decline at an
expected rate of 0.75 percent per year over the forecast horizon, we think the
market is currently not too high (or too low), and our repricing forecast is zero.

Bringing It All Together

In this section, we estimate the expected total nominal return on equities, as
expressed in Equation 3, using the inputs we derived in the foregoing sections.
We then subtract the 10-year nominal Treasury bond yield to arrive at our
estimate of the ERP over the next 10 years.
Income return (D/P – S) = 1.78 percent dividend yield
– (–0.2 percent repurchase yield net of dilution)
= 1.98 percent.
Capital gain (i + g + PE) = 2.4 percent inflation
+ 1.8 percent real per capita GDP growth
+ 0.85 percent population growth
= 5.05 percent.

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Rethinking the Equity Risk Premium

Total expected equity return = 1.98 percent + 5.05 percent

= 7.03 percent (rounded to 7 percent)
– 3.40 percent 10-year Treasury bond
on 22 April 201121
= 3.6 percent expected ERP over 10-year Treasuries.

Arithmetic vs. Geometric Mean Forecasts

Our forecasts thus far have been geometric means (rG ). To estimate the
equivalent arithmetic mean return expectation (rA ) for use as an optimizer
input, we rely on the following approximation:

1  rG  1  rA   . (4)
We use standard deviations drawn from 1970 to 2010 because we do not
necessarily expect bond returns to be as placid as they have been recently. Thus,
for the purpose of estimating standard deviations, we include this long period
because it includes the bond bear market of 1970–1980 and the dramatic
subsequent recovery.22 We obtain the following:
Expected arithmetic mean equity total return = 8.59 percent.
Expected arithmetic mean 10-year Treasury bond total return = 3.96 percent.
Difference (expected arithmetic mean ERP) = 4.63 percent.
A limitation of this study is that we use U.S., not global, macroeconomic
data in our estimate of the expected return on the S&P 500. The S&P 500 is
a global index, in that it contains many companies that earn most, or a
substantial share, of their profits outside the United States. Perhaps global
economic growth rates are more relevant to the expected return on the S&P
500 than U.S. growth rates. Future research should examine this possibility.

Assessing the Previous Grinold and Kroner Forecast

Grinold and Kroner (2002) identified three camps of ERP forecasters: “risk
premium is dead,” “rational exuberance,” and “risk is rewarded.” They called the
first two views “extreme” and wished to be counted among the moderate “risk is
rewarded” camp, in keeping with the belief that markets are generally efficient
and that prices, therefore, do not stray far from genuine values for very long.

21 Thisnumber was obtained from Yahoo! Finance on 22 April 2011.

22 Stocks = 17.68 percent; bonds = 9.73 percent (these data are from Aswath Damodaran’s
website,, as of 3 June 2011).

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Grinold and Kroner’s (2002) forecast, evaluated over 2002–2011, was too
high. The main problem was the volatile repricing term. They seriously under-
estimated the speed with which the unusually high P/Es that then prevailed
would revert toward their historical mean. In this paper, we forecast a repricing
of zero, consistent with our view that the market is finally, after two bear
markets and two recoveries, roughly fairly priced. Because the repricing term is
noisy, we know that our current forecast is more likely to be too high or too low
than just right when evaluated over the next 10 years. We believe, however, that
we have identified the middle of the range of likely outcomes. Although black
swans, fat tails, and tsunamis are the talk of the day, such large unexpected
events tend to fade in importance as they are averaged in with less dramatic
events over extended periods and the underlying long-term trends reveal
themselves once more.23 We expect moderate growth in the stock market.

The authors thank Antti Ilmanen for his very generous

contribution of a number of different data sources and for his wise counsel.
Paul Kaplan also provided helpful advice and contributed invaluable data.

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70 ©2011 The Research Foundation of CFA Institute